Pension tension

In terms of sectors to watch, the American market is more homogenous than Canada, where the largest deficits are concentrated in the industrial and telecom segments. In the U.S., companies across all sectors have pension concerns. Any company with a large unionized workforce has the potential to run into problems, making pensions one of the major issues we examine in our U.S. accounting-focused model portfolios.

For company pension plans, there are various issues to watch—too many to cover here—that fall into two categories: accounting or accrual impacts, and cash-flow concerns.

Accounting impacts include:

• reported deficits
• accounting discount rates
• the balance sheet
• reported earnings

These factors impact valuation, but generally don’t influence share prices the way cash-flow issues can.

Changes in funded status impact the balance sheet, and should theoretically affect share prices through price/earnings ratios, with an increase in pension deficit acting similar to additional corporate debt. Funded status refers to the degree to which pension plan assets (investments) cover off the plan’s estimated liabilities. The key word here is estimated, because companies can drag their feet when it comes to recognizing the full impact of decreasing interest rates (see “Beware company pensions”).

When high discount rates make sense

A higher rate is not necessarily unjustified. Bloomberg reports utility company AES Corp. uses a discount rate of 8.8% compared to peers Centerpoint Energy (5.3%), Sempra Energy (5.0%), AGL Resources (4.6%), and NiSource (4.6%). But, digging into financial statements reveals that AES uses a rate of just 4.7% for its U.S. operations, and the high Bloomberg rate is an average that’s heavily influenced by the company’s operations in higher-inflation Latin America.

Given the slow response of some companies, there might be much more than the reported $458 billion of underfunding that’s currently spread across the S&P 500. This is where attention is focused because falling interest rates should prompt companies to lower their pension obligation discount rates, thus increasing their deficits. Current discount rates on S&P 500 companies range from under 3% to over 9%, implying that some companies might be hiding liabilities from shareholders through lax management and auditing (see “When high discount rates make sense,” right).

Chosen discount rates can also fluctuate based on when companies expect to pay their pension obligations, with most choosing a blended rate based on the yield curve of high-grade corporate bonds.

Another issue to consider: increases in plan assets can help mitigate ballooning obligations. But asset returns in 2011 lagged behind longer-term historical returns, adding to the drag on funded status suffered by many companies.

Declining rates have less of an impact on reported earnings, and therein lies some danger. Since the impact doesn’t stick out like a sore thumb as it does on the balance sheet, advisors risk forgetting about the potential impact until it’s too late, and quarterly earnings miss the consensus target. Decreases in interest rates usually result in increases to pension expenses and lower earnings (the exception is with mature plans where decreasing interest costs outstrip increasing service costs).

While the impact of accounting issues can and should influence share prices, they are nowhere near as attention-grabbing as cash-flow issues. Companies are required to make cash infusions into their pension plans when they fall below certain funding thresholds, and these capital calls can represent significant drains on operating cash flows. Verizon, for instance, is planning to ante up $1.26 billion for its pension plans in 2012—an increase of almost $750 million over the previous year.

Verizon stepped up its contributions in 2012 because its funded status fell to 79% from 87% as a result of poor asset returns and declining interest rates in 2011. The general threshold when estimating the potential for obligatory cash infusions is 80%.

However, funding requirements are far from straightforward. They aren’t consistent across companies or industries, and tend to change over time through political decisions made in reaction to economic downturns.

As well, the 80% rule doesn’t apply to accounting figures in financial statements. The 80% rule applies to calculations in compliance with the U.S. Employee Retirement Income Security Act (ERISA), which is like using a different set of books altogether. Advisors might be able to find the odd reference to ERISA credits scattered around financial statements, but generally, disclosure in this area is wholly inadequate.

Even so, the American Academy of Actuaries argues an 80% funded status doesn’t necessarily constitute a healthy plan, and factors such as size relative to the sponsor, health of the sponsor, and risk levels in the investment plan are also important considerations.

Another wildcard in the scenario is the potential for funding relief enacted by lawmakers, such as the Pension Relief Act of 2010. Under those provisions some companies have adopted the two-plus-seven schedule (interest only for two years and then accelerated amortization over the next seven), while other companies have opted for the very lenient 15-year amortization period.

More relief could also be on the way in 2012, with Congress looking at legislation to put a floor on the rates that companies must use to discount their obligations (presumably to provide a longer-term outlook). If enacted, rate floors would go much further in aiding companies than the previous changes to amortization periods.

When estimating whether companies will face a cash squeeze, there are many interrelated factors to consider. Overall, it’s best for advisors to regard each company’s situation as unique, and avoid making generalizations or assumptions.

Unfortunately, the cash-flow side is hard to predict due to a deficiency of harmonious regulations and missing information from company financial statements.

While advisors will need to dig that much deeper, it’s better than being surprised by a downgrade prompted by pension concerns.

Just look at the stock of Safeway, the U.S.-based supermarket chain. While shares of its peers are up, the grocer has declined almost 25% since late March when it was revealed the company’s balance sheet was missing roughly $6.7 billion in pension liabilities due to weak disclosure and accounting requirements.

DR. Al Rosen , FCA, FCMA, FCPA, CFE, CIP and CIP and Mark Rosen, MBA, CFA, CFE run Accountability Research Corp., providing independent equity research to investment advisors across Canada.